Help! Advice to a young naval officer

Commentary: Investment advice for those just starting out

BOSTON (MarketWatch) — I recently got an email from a young officer in the U.S. Navy.

“Mr. Arends,

I am reaching out to you for advice as to where to invest my Roth IRA.

I am a 26-year-old naval officer stationed in [….] I have been deployed twice to the Middle East. Each year since 2004, I have diligently maximized my annual Roth IRA contribution and placed the funds in a cash reserves account earning less than 1%. I feel that the funds should be invested in something earning a better return.

If you were 26 years old where would you invest your Roth IRA? Do you recommend any mutual funds or should I invest in individual stocks? My tolerance for risk in this account is moderate to high, given that I do not plan to withdraw the funds until I am 60 years old. With that being said, I do not want to get overly aggressive and make a poor decision in our current market.

Given my profession, I often do not have time to monitor my investments on a daily or weekly basis. Your advice is much appreciated.

Very respectfully,

[…]

It got me thinking. I get so irritated hearing Wall Street blowhards bragging about how they “pulled the trigger” on a trade that it was refreshing to hear from someone who knows what that expression really means.

And I hate to think of the same Wall Street crowd getting its hooks into this guy’s money while he’s out serving on their behalf.

So I started to think about where he should start with his investments. My response comes in two parts.

“Dear Lieutenant …

Thank you for your email. And, more importantly, thank you deeply for service to the country.

Bravo for opening a Roth IRA so young, and making the maximum contribution each year. You are already ahead of the game. At your age most people are borrowing and spending rather than saving. You are going to want that money when you are older.

A Roth is definitely the way to go: That money will grow tax-free for your retirement. And the earlier you start investing, the better you should do because you have more time for the money to grow.

By my math, you should have about $35,000 invested so far.

You’re right, cash as a long-term investment is a bust. Right now you’re getting 1% interest. Consumer prices are rising by about 3%. Do the math, as they say. In your fear of losing money on Wall Street, you are instead losing money to inflation.

Historically, investors have been able to earn 5% a year above inflation over the long term.

So how should you invest your money?

Let’s start by saying how you should not invest.

The first piece of advice I’d give you is I wouldn’t bother picking individual stocks. Do yourself a favor: Invest in mutual funds.

You’re busy. You’re working full-time, and you will presumably be away on tour for long periods. Investing in individual stocks is hard, time-consuming, and surprisingly expensive in commissions.

It’s unnecessary. Over time the overwhelming bulk of your returns aren’t going to come from individual securities. They’re going to come from picking the right assets — stocks versus bonds, and so on.

Sure, you probably know somebody who’s made a fortune on, say, Apple, but such cases are rare.

(Typically such popular “growth” stocks will lose you more money than they make you anyway. For every Apple
AAPL, -0.32%
there was a Krispy Kreme
KKD
or a Sirius XM Radio
SIRI, -0.65%
where the stock crashed. There is fascinating research which shows that in general you are actually much better off investing in Wall Street’s ‘dogs’ — the stocks that nobody wants — than the ‘stars.’)

The second piece of advice is to watch out for Wall Street. It is just dying to sucker you into investments for high fees. Over time they will kill your returns. Wall Street has grown rich off commissions and fund management fees. (The worst offenders are the hedge-fund managers.) As the old joke goes, the traders and salesmen end up with expensive yachts, but you will hunt in vain for the customers’ yachts. All things being equal, look for investments, such as mutual funds, that charge you low fees.

So how should you invest?

I’m going to start by laying out some conventional advice. It’s not wrong, and if you are busy, and have neither time nor inclination to go further, it should serve you well over the next three or four decades.

The conventional wisdom on Wall Street is to recommend a standard portfolio of 60% stocks and 40% bonds, and to rebalance it once or twice a year — selling what’s risen, and spending the money to buy what’s fallen — to restore the original allocation. Someone of your age might cut the bond allocation down to 20%, or even lower, on the grounds that you can afford to take on more “risk,” by which Wall Street means volatility, if you feel comfortable with that.

But a simple 60/40 portfolio, or an 80/20 one, has a number of flaws. It misses out on some investment classes. And it is far too heavily weighted toward U.S. investments. That would have cost you plenty over the past decade. Contrary to what you hear, overseas investments are not necessarily more “risky.”

If you want to cut your bond allocation, you could put 25% in each of the three stock funds and 7.5% in each of the two bond funds (and leaving the last two funds unchanged).

(New so-called “lifecycle” funds, which are tailored to your age and target retirement date, do the whole allocation for you. They have mostly stocks when you are young, and raise the bond portion as you go higher. I don’t like them very much because they are all far too heavily weighted toward U.S. stocks, and generally give you too little weight, if any, in commodities and precious metals.)

The theory behind this is diversification. Over the long term, stocks have outperformed bonds, but they have been more volatile. Precious metals offer portfolio insurance: They have typically done best when everything else has done badly. Commodities offer protection against inflation, and, perhaps, the rising danger of global shortages.

Capping off this strategy is the principle of dollar cost averaging. That means investing your money slowly, over time. Don’t commit all your funds at once. That way you’ll minimize the risk of buying at the top. If some securities are expensive today, they will fall in due course. So even though you’ll overpay for those you buy now, you’ll probably get a bargain on those you buy later.

So if you had, say, $10,000 to invest, you could decide to invest $1,000 every quarter for the next two and a half years. Based on the portfolio above, that would mean investing $200 in each of the three stock funds, $150 apiece in each of the bond funds, and $50 apiece in the commodity and gold funds. (One technical note: You will pay trading commissions on the commodity and gold funds, as they are exchange-traded, so you might want to invest more in them, at fewer intervals, to keep those commissions down.)

If you go down this route, you have to stay disciplined. Ignore the headlines. Ignore your emotions. Ignore greed, fear, or the mood of the market. Just keep investing exactly the same amounts of money into the same investments at the same intervals, and forget all about it.

This, as I say, is the conventional wisdom. And over the next 35 years it should do you just fine. It will require minimum effort on your part. The fees will be low. It’s easy.

But it’s not your only option.

In my second post I’ll tell you the problems with this approach — and how you might do things differently.

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